Hedge Funds' Higher Returns Come At A Price

Mutual funds are familiar to many people, but unless you work in finance, hedge fund are probably more of a mystery. If you've ever wondered about hedge funds or whether they might work for you, read on to learn more about this enigmatic investment. RegulationThere have been rumblings about making hedge funds register with the Securities and Exchange Commission (SEC), but as of yet, the single biggest difference between mutual funds and hedge funds is that mutual funds are highly regulated. In the U.S., mutual funds and mutual fund companies are regulated by the SEC under the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisors Act of 1940. Hedge funds, on the other hand, bypass regulation by structuring themselves to be exempt, although they are subject to antifraud standards. (Learn which country has the strictest rules on mutual fund construction and why, in How Mutual Funds Differ Around The Globe.)

LeverageWhen a hedge fund employs leverage, it borrows money to achieve a higher return. If it can achieve an average return (the numerator) on a smaller capital base (the denominator), simple division dictates that it amplifies its rate of return. It's the same thing that happens when an individual buys stock on margin in a brokerage account. Leverage can also be employed by entering "cashless" derivative transactions. This is extremely common in all types of hedge funds. With a derivative, you don't have to employ all your cash to command a large notional amount. This way you can invest and earn returns greater than if you had to invest all of your cash in just stocks or bonds.

Using leverage affords you higher returns, but also involves higher risk, as leverage works on both the up- and downside - it amplifies gains and losses. This is why hedge funds are often categorized as higher risk/higher opportunity investments, and why you hear about hedge fund blow-ups in the media. If a fund is highly levered and the market doesn't move in a favorable way, the fund can lose a lot of money very quickly. (Learn why hedge funds collapse and how to avoid making the same mistakes, in Hedge Fund Failures Illuminate Leverage Pitfalls.)

How Hedge Funds Can Achieve Higher ReturnsLeverage isn't the only way hedge funds can achieve higher returns versus mutual funds; hedge funds also have the power to go short. Therefore, hedge funds should be able to make money in down as well as up markets. Traditional mutual funds are open to more systematic risk, as they can only be long on a position. If the mutual fund manager doesn't like a particular company or sector, he or she can choose to not buy that company's stock, but the fund manager can't short it and make profits as the stock price declines. By picking and choosing the right companies in which to invest, a traditional mutual fund can still beat its benchmark, but it might be harder to make money in a bear market. (For related reading, see in Surviving Bear Country.)

Other DifferencesMutual funds are required to value and price their portfolios daily. For example, every stock in a large cap stock fund must be valued at its closing price and the resulting net asset value (NAV) must be calculated for investors. In the hedge fund world, valuations may only be available on a quarterly or monthly basis. This can be partially due to some of the more exotic positions certain hedge funds might hold, such as over-the-counter (OTC) derivatives, on which daily prices are not available.

Fee structures are another difference between mutual funds and hedge funds. When you purchase mutual fund shares, you might pay a commission. You will also be charged some management fees; it is extremely unlikely that these fees will be tied to performance. In the hedge fund world, the portfolio manager also charges a management fee. The management fee is charged in addition to a performance fee, which can only be collected by the manager if the fund makes money. Most management fees are 1-2%, and performance fees are traditionally 20%.

The rules pertaining to the marketing of hedge funds are very specific. Non-registered hedge funds may not solicit for contributions. This differs from the rules fro mutual funds, which advertise heavily. The hedge fund manager must have a pre-existing relationship with a potential investor. It is also acceptable to be introduced by a qualified intermediary, which may be the hedge fund's prime broker. Potential investors must also meet income or net-worth requirements. Those that meet these requirements are called "accredited investors" or "qualified purchasers". (Find out how average investors are breaking into what was once reserved for the rich, in Hedge Funds Go Retail.)

The Bottom LineThe appeal of hedge funds is the lack of constraints, which allows skilled portfolio managers to achieve higher returns. The ability to short and employ leverage allows hedge funds to potentially make more money than their mutual fund counterparts. The performance fee structure also theoretically aligns the interest of the investors with those of the portfolio managers because managers make the most money when they are achieving high returns for the fund's investors. But all of the advantages of hedge funds can become a nightmare if the fund is highly leveraged and the market moves in a direction opposite of the manager's opinion. The higher opportunity is why hedge funds have proliferated over the last 15 years, and the higher risk is why we sometimes hear about the more spectacular hedge fund blow-ups. (To read about some failed hedge funds, see Massive Hedge Fund Failures, Dissecting The Bear Stearns Hedge Fund Collapse and Losing The Amaranth Gamble.)